When a financial instrument’s value relies on mere perception, or just because many believe that it is valuable, will it be worth having?
What if it is highly volatile, unregulated, and beyond the control of state regulators?
Despite the risks, but buoyed by an adept marketing campaign and spirited lobbying in US Congress, Bahamas-based FTX [Cryptocurrency Exchange] has raised $2 billion from some of the top venture capitalists in the world, including Sequoia Capital, SoftBank, BlackRock, Thoma Bravo, and Altimeter Capital. Sports and entertainment superstars such as NBA’s Golden State Warrior’s Stephen Curry and Klay Thompson, and Hollywood’s Matt Damon, among many others, have been swept by the crypto craze.
The collapse of Sam Bankman-Fried’s FTX which resulted in the evaporation of billions of dollars into thin air reflects the get-rich-quick mindset of many investors. It has also spiraled debates about the lack of protection for investors and intensified questions as to what role should the state have in an industry known for its anti-establishment culture. Crypto is a concept child of a better world where the establishment’s power over money and finance ends.
Judd Legum, founder and author of Popular Information quipped: “None of the venture capital firms conditioned their investment with a seat on the board of directors to independently oversee its activities. Moreover, these firms didn’t even require Bankman-Fried to create a real board of directors…. What were these wealthy investors thinking?”
Indeed! I have always doubted the viability of the crypto market. Under its system, your investment is not guaranteed. When you invest in the US dollar, you have the US Treasury securing your investment through its tax generating ability. Shares of stocks are supported by the income and expansion of the companies you invest in, while buying real estate has the value of the physical lot and/or building having your back.
What is cryptocurrency?
You may have come across the most recognizable among the many names given to cryptocurrency: Bitcoin, Litecoin, and Ethereum. Its use can be compared with fiat currencies to exchange for goods, services and investments. While fiat currencies are government-issued, much like the money we have grown accustomed to, crypto is not. It should not also be confused with digital currency. The latter can be used as cash by going to an ATM or bank because it is backed by a financial institution. Transactions with cryptocurrency are recorded on the blockchain and are not certified by a financial institution. The blockchain, on the other hand, is a financial ledger or a database, if you will, which stores electronic information digitally to show ownership.
Crypto functions using encryption algorithms which ensure that cryptocurrencies are both used as a currency as well as a virtual accounting system. A crypto wallet is needed to use cryptocurrencies. These wallets are cloud-based apps which can be stored on your computers or mobile devices. These wallets serve as tools that secure your encryption keys that hide your identity and link to your chosen cryptocurrency.
Cryptocurrency was borne out of an idea of a currency that could not be traced and could not be centralized. Remember DigiCash? In the 1980s, David Chaum, an American cryptographer, created it. It was the first form of electronic payment which required software and encrypted keys to send and withdraw money. Then came Bit Gold, the precursor to Bitcoin which Nick Szabo designed in 1998.
In the same year, Satoshi Nakamoto published Bitcoin – A Peer-to-Peer Electronic Cash System, which described Bitcoin as “an electronic payment system based on cryptographic proof instead of trust.”
Crypto’s popularity has grown through the years, catapulting Bitcoin and other currencies from a mere hobby for “tech nerds” into a global cultural force. Crypto giants such as FTX spent millions hard-selling investors with Super Bowl commercials and pricey marketing campaigns.
The success of Bitcoin spawned other forms of cryptocurrencies (such as Ethereum, Dogecoin, Tether, XRP, Solana, PolkaDot, Cardano, Shiba Inu, Binance Coin, USD Coin) which are transacted in exchanges including FTX, Binance, Coinbase Exchange, Kraken, KuCoin, Bitfinex., Gemini and Coincheck.
What went wrong?
The crypto crash was precipitated by the collapse of FTX, one of the world’s largest cryptocurrency exchanges. It opened the floodgates of volatility in the highly speculative digital asset market. The fortune of FTX’s founder, Bankman-Fried, went from nearly $16 billion to zero within days as his crypto empire begged for bankruptcy protection in the US on November 11.
The FTX freefall began when the balance sheet of a crypto investing firm, Alameda Research, which was also owned by Bankman-Fried, was published by CoinDesk, a crypto-focused digital media website. It revealed that Alameda held a large amount of a digital currency created by FTX called FTT. Although FTT held a certain market value, Alameda would be at risk of insolvency, if the price were to drop.
The digital token FTT is similar to cryptocurrencies like Bitcoin. To encourage people to use their services, many crypto platforms create their own tokens and offer perks to their buyers. These tokens can then act like stock in the platform.
“Bankman-Fried has so far explained that a mistake in internal labeling had led to customer deposits being used to fund his hedge fund. This is important when you’re trying to come up with a legal theory that lets you off the hook: Look, it was bad, but it was an accident,” wrote Kevin T. Dugan in New York Magazine. “[But] If a back door built into the company’s code is only known to or accessible by the top executive (or something like that), it starts to get at something prosecutors really salivate over: intent. White-collar crime is difficult to prove, in large part because someone’s state of mind is crucial to demonstrating that something was an intentional fraud. How do you explain a back door as inadvertent?”
Can FTX be held responsible? Cornell University economics professor Eswar Prasad said that FTX’s Bahamas residency puts it outside financial reporting requirements which US companies must meet.
According to Megan McArdle of The Washington Post, despite all the prophecies made that crypto will bring about change that will shake the world, “[C]rypto remains primarily the province of hobbyists, speculators and gurus… It took a lot of work to make the stock market boring enough to attract the wealth of more than half of all American households, a lot of institution-building to control fraud and limit the fallout from speculation.”
McArdle said that to become “a world-changing financial technology, [crypto] will need to take the same journey…. Decentralized finance! Permissionless innovation!…. This all sounds very exciting when crypto nerds talk about it… But at present, too much of this freedom is being used to reinvent financial architectures that were de-permissioned for good reason – including the self-dealing clearinghouse, the undercapitalized market-maker and the Ponzi scheme. Crypto must find some way to rein this in, or let government do it. Otherwise, the best-case scenario is that it will remain irrelevant to the larger economy, as ordinary folks stick with the old-fashioned money they understand and the institutions they feel they can trust.”
Such a scenario mimics what happened in the 17th Century when tulips – yes, those large spring-blooming, brightly colored, perennial flowers that belong to the lily family – became a sought-after investment instrument.
In Holland during the early to mid-1600s, speculation drove up the value of tulip bulbs to such a height that buying tulips became a mania. At the market’s peak, the rarest tulip bulbs traded for as much as six times the average person’s annual salary. Unfortunately, the Dutch tulip bulb market bubble also became one of the most famous market crashes of all time.
In his 1841 book Extraordinary Popular Delusions and the Madness of Crowds, the Scottish journalist Charles Mackay opined that “crowds of people often behave irrationally.” The tulip mania caught the attention of the entire nation, with the entire population, “even to its lowest dregs, [embarking in the tulip trade”.
By 1635, a sale of 40 bulbs for 100,000 florins (also known as Dutch guilders) was recorded. By way of comparison, a “tun” (930 kilograms or 2,050 pounds) of butter then cost around 100 florins and “eight fat swine” cost 240 florins, while a skilled laborer earned a mere 150 to 350 florins a year.
Only one year later, tulips were being traded on the exchanges of numerous Dutch towns and cities, participated in by all members of society. Mackay recounted people selling possessions in order to speculate on the tulip market. They were offering five hectares of land for one of two existing Semper Augustus bulbs, or a single bulb of the Viceroy that was exchanged for a basket of goods worth 2,500 florins.
As a pamphlet from the Dutch tulipomania, printed in 1647, noted: “Many individuals suddenly became rich. A golden bait hung temptingly out before the people, and, one after the other, they rushed to the tulip marts, like flies around a honey-pot. Every one imagined that the passion for tulips would last for ever, and that the wealthy from every part of the world would send to Holland, and pay whatever prices were asked for them. The riches of Europe would be concentrated on the shores of the Zuyder Zee, and poverty banished from the favored clime of Holland. Nobles, citizens, farmers, mechanics, seamen, footmen, maidservants, even chimney sweeps and old clothes women, dabbled in tulips.”
The prices of tulip bulbs rose higher and higher as people intended to resell them at a profit. Naturally, such a scheme could not last unless someone was ultimately willing to pay such exorbitant prices. In February 1637, tulip traders could no longer find new buyers willing to pay increasingly inflated prices for their bulbs. As realization set in, the speculative bubble burst. Demand for tulips collapsed, and prices plummeted. Some of those resellers were left holding worthless contracts to purchase tulips at prices now 10 times greater than those in the open market, while others found themselves in possession of bulbs now worth a fraction of the price they had paid.
Mackay recounted that “the Dutch devolved into distressed accusations and recriminations against others in the trade.” The panicked tulip speculators sought help from the Dutch government, which responded by declaring that anyone who had bought contracts to purchase bulbs in the future could void their contract after paying a 10% fee. Attempts made to resolve the situation to the satisfaction of all parties proved unsuccessful. The mania finally ended, with individuals left stuck with all the bulbs they held at the end of the crash. No court enforced payment of any contract, since judges regarded the debts as contracted through gambling, rendering them unenforceable by law.
There were lesser tulip manias which occurred in other parts of Europe, but never reached the state that the Dutch experienced. Mackay reported that the aftermath of the tulip price deflation led to a widespread economic chill throughout the Netherlands for many years after.
If the story of tulip mania had not been relegated to the dustbin of history, it could have served as an allegory for the snares that excessive greed and speculation in investing can lead to. – Rappler.com
Val A. Villanueva is a veteran business journalist. He was a former business editor of the Philippine Star and the Gokongwei-owned Manila Times. For comments, suggestions email him at email@example.com.